Asset Classes: Bonds
Kerry Back
BUSI 721, Fall 2022
JGSB, Rice University
Bonds
- Pay a specified coupon at regular intervals (usually semi-annually).
- Plus pay face value (= par value) at maturity. Last payment is coupon plus face.
- Issued at market prices. Usually coupon is set so they can be issued roughly at face value.
- When market rates are high, coupons are set high. When market rates are low, coupons are set low.
Treasury Auctions
The U.S. Treasury borrows money by issuing bonds of various maturities at regular intervals. They solicit bids of the form
“I will pay face value if the coupon is at least \(\text{x}\).”
Bidders willing to accept low coupons get their bids filled, and the coupon paid is the lowest that will sell the entire issue.
Individuals can buy bonds at auction via Treasury Direct with simpler bids: “I want xx number of bonds.”
These “noncompetitive” bids are filled first and then the coupon is determined by the competitive bids.
Treasury Inflation Protected Securities (TIPS)
The face value of a TIPs is adjusted for inflation.
The coupons are a fixed percentage of the face value, so they rise with inflation too.
The result is that the income you get from a TIPS is fixed in constant dollars.
8D
How Corporate Bonds are Issued
Usually hire an investment bank, who assesses demand from pension funds, insurance companies, brokerages, \(\ldots\)
Investment bank advises on the coupon needed to sell the bonds at par.
Investment bank will distribute. It may guarantee sale to company or make “best efforts.”
Corporate Bond Provisions
- Bonds often contain some covenants that restrict the company from doing certain things - for example, a change of ownership, issuing more debt, or paying “excessive” dividends.
- Bonds may be subordinated - some bonds issued by a company may be subordinated to other bonds of the same company, meaning that the latter get paid first in bankruptcy.
- Bonds may be callable, meaning that the company has a right to prepay - usually only after some time has passed and usually at some penalty.
- Bonds may also be puttable, meaning that the investor has the right to demand immediate payment in some circumstances.
Asset Backed Securities
- Asset backed securities are bonds that are issued by a trust and are to be repaid from income generated by assets held by the trust.
- A major category is mortgage-backed securities, including those issued by FNMA, GNMA, and FHLMC, better known as Fannie Mae , Ginnie Mae, and Freddie Mac.
- There are also securities backed by auto loans, credit card receivables, etc.
Bond Trading
The bond market is largely an institutional market, with trades being made in large quantities through dealers.
- Security dealers are like car dealers, standing ready to buy or sell and profiting from the spread.
- Dealers publish indicative prices but direct contact (phone or electronic) must be made to get firm quotes.
Generally, the best way for an individual to own bonds is through a mutual fund or ETF.
